Here is a riddle: Would you rather pay taxes now or pay taxes later? As the son of a CPA (and a CPA myself), I’ve always believed in the old tax adage, “Accelerate deductions and defer gains.” Therefore my default answer to this question is to pay taxes later. However, you may question this logic if the tax you expect to pay later is significantly higher than the tax you would pay today. Herein lies the challenge of deciding whether or not to convert your retirement account to a Roth IRA.

It’s no secret that converting pre-tax assets from traditional 401(k)s and IRAs to Roth IRAs has become a popular planning technique ever since 2010. That’s when lawmakers repealed the income limits on Roth IRA conversions. In my experience, this strategy works for many clients, but is not a fit for everyone. Again, a Roth IRA can be a great planning tool – if it makes sense for you.

Should you convert?

If you fall under the IRS income limits (see table below), contributing directly to a Roth IRA has many potential benefits.

Phase-outs for Roth IRA eligibility: Modified adjusted gross income

So if you earn too much to qualify for a Roth IRA, what can you do? Well, if it makes sense, you can contribute indirectly by using a “Backdoor Roth IRA” as we discussed in a previous post. Or you can take pre-tax assets and convert them to a Roth. The strategy gives you the ability to pay tax now on the converted funds for the benefit of never paying tax again on the funds and the related earnings. This strategy has advantages and disadvantages, which we’ll analyze below:

Benefits of converting to a Roth IRA

Tax-deferred growth. Like other retirement accounts, growth within a Roth IRA account is protected from taxes.

No required distributions. Other retirement accounts–including Roth 401(k)s–require you to begin withdrawing money when you turn 70 ½, whether you need the money or not. There is no such requirement for a Roth IRA, which means your funds can grow tax free for the remainder of your life–and beyond!

Great estate planning tools. Much like life insurance, funds in a Roth IRA can be passed to an heir, can avoid probate, and can be used tax-free by the beneficiary. Roth IRA funds can also be “stretched” potentially over the beneficiary’s life which allows for further (tax-free) compounding growth! Needless to say, Roth IRAs can be very powerful tools for passing on wealth to the next generation.

Disadvantages of converting to a Roth IRA

Immediate tax burden. When you convert to a Roth IRA you face an immediate tax hit. For example, if you are converting a $10,000 traditional IRA to a Roth IRA and you are in the 33 percent marginal tax bracket, you will owe a tax of $3,300 in the year of the conversion.

Tax rates change. If you convert and the tax rates you pay upon conversion are much higher than when you withdraw the funds, the conversion could have been a bad choice. No one knows what future tax rates will be, so converting can be a “leap of faith” to a degree.

Tax paid from IRA. If you have to use money from your IRA to pay the taxes on the conversion, those funds will not be able to compound tax-free. Consider using funds from outside assets to pay the tax to get the most bang for your buck.

Tax rate of beneficiary. If the beneficiary of the Roth will be in a much lower tax bracket than you, they may receive more money by inheriting the pre-tax assets. Always keep your beneficiaries in mind when performing a Roth IRA conversion.

Conclusion

In Part 2 of this post, we’ll go through an example of how a Roth IRA conversion works, who is a good fit for this type of transaction, and how you can potentially “re-do” a conversion if it doesn’t work out. In the meantime, please contact me if you’d like to discuss whether or not a Roth IRA conversion makes sense for you.